Greek debt standoff casts cloud over EU summit

WilliamL. Watts

FRANKFURT (MarketWatch) — European leaders and banks failed to reach an agreement Wednesday on the size of losses financial institutions should take on Greek government debt, undercutting efforts by euro-zone officials to draft a comprehensive plan to contain the region’s long-running debt crisis at a closely-watched summit meeting in Brussels.

Charles Dallara, the managing director of the Institute for International Finance, a Washington-based trade group that represents the world’s largest banks, said no agreement had been reached on writing down Greek government debt.

“There has been no agreement on any Greek deal or a specific ‘haircut,’” Dallara said in a statement. “We remain open to a dialogue in search of a voluntary agreement. There is no agreement on any element of a deal.”

German Chancellor Angela Merkel and French President Nicolas Sarkozy were reportedly set to meet with banking industry representatives as a meeting of 17 euro-zone leaders continued into the early hours of Thursday morning.

Earlier, leaders of all 27 European Union nations agreed to call on Europe’s biggest banks to boost their ratio of top-quality, or Tier 1, capital to 9% by June and confirmed they were working on a plan to provide medium-term funding guarantees for European banks in an effort to avoid a credit crunch.

Leaders also reportedly agreed on a plan to boost the lending power of the €440 billion euro-zone bailout fund, or EFSF, to around €1 trillion. The boost in firepower won’t require additional funding by euro-zone members, instead relying on a long-discussed plan to use the facility to insure bonds against initial losses, Reuters reported, and the establishment of a special investment vehicle.

News reports said French President Nicolas Sarkozy was scheduled Thursday to talk to Chinese President Hu Jintao about participating in the investment vehicle.

Greek writedowns crucial

The issue of writedowns is crucial to the overall effort to address the crisis.

The larger the losses borne by private bondholders on Greek debt, the less taxpayers will have to bear in bailing out Athens. Larger writedowns also mean a bigger reduction in Greece’s outstanding debt, which is seen by many economists as unsustainable without a sharp writedown of 50% or more in the value of the country’s bonds.

News reports this week said European officials have pressed for writedowns on the face value of Greek bonds of as much as 60%, while the Institute of International Finance has resisted calls for a cut of more than 40%.

The inability of banks and governments to reach agreement could stir fears private bondholders could be forced to accept an involuntary writedown, potentially constituting a “credit event” that would require the payout on billions of euros in credit default swaps, instruments used to insure debt against non-payment. That could further destabilize the European banking sector.

The standoff has tried the patience of some observers, who contend European officials should take a harder line on the banks.

The banks “have to be held accountable for having used greed as a reason to invest so heavily in bad debt that offered a high yield simply because it was junk to begin with,” said Stephen Pope, managing director of Spotlight Ideas. “Quite frankly, whoever is going to be in charge of recapitalizing the banks has to face up to them and state without any room for misunderstanding: 60% haircut or no capital funding.”

Economists at Barclays Capital said a “hard restructuring” of Greek debt is unlikely amid opposition from the European Central Bank. A number of safeguards would need to be put in place in order to prevent a run on Greek financial institutions, which hold an estimated €80 billion in Greek debt, they said.

The EFSF meanwhile, is seen as crucial to convincing investors euro-zone authorities have the firepower necessary to prevent the debt crisis from engulfing Italy and Spain.

Indeed, Italy, the euro zone’s third largest economy and the home of the world’s third-largest debt market, remains in focus.

Italian Prime Minister Silvio Berlusconi was put under heavy pressure by Merkel, French President Nicolas Sarkozy and other EU leaders at Sunday’s summit to implement more far-reaching measures aimed at reducing the country’s debt level, which at around 120% of gross domestic product is second only to Greece in the euro zone.

Berlusconi averted a collapse of his coalition government Tuesday night after negotiating a compromise with a major coalition partner on raising the nation’s retirement age, news reports said.

Italy’s 10-year bond yield (10YR_ITA) rose 5 basis points to 5.90% on Wednesday, according to FactSet Research. The yield breached 6% last week for the first time since the ECB began buying bonds in early August in a move economists saw as an effort to prevent Italian borrowing costs from hitting unsustainable levels and worsening a feedback loop between sovereign debt and bank debt.

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